Analysts Running Scared

Why Wall Street is incapable of calling things right.

By now, it should be news to no one that Wall Street analysts were hopeless romantics in the 1990s. Smitten with tech-stock love, they fell head over heels for unrealistic growth expectations, "eyeball"-based business models, and all things dot-com.

When the bubble burst in early 2000, these love-struck analysts were caught with their analytical pants down. As tech stocks plunged from stratosphere to lithosphere, a whopping 95% of all equity issues then trading on the public markets were totally free of any "sell" ratings. What's more, according to investment research firm Zacks, the 5% of stocks that did have a sell rating had exactly that: one sell rating. Every analyst in the country, with the exception of a single lone crank, refused to cast doubt on these most doubtfully priced of companies.

And then what happened through the end of 2001?

Yahoo!(NASDAQ:YHOO): down 93%.

Priceline.com(NASDAQ:PCLN): down 89%.

Sapient(NASDAQ:SAPE): down 88%.

Things change, yet remain the sameAfter the bubble's "pop," a new trend emerged. Stock analysts began to reverse themselves, advising investors to sell what was left of their stocks.

And so the stocks began to rise.

From 2000 to 2004, stocks that the Street told you to sell rose 19% per year on average. Meanwhile, the "buys" and "holds" rose just 7%.

So is Wall Street just stupid?No. On the contrary, the analysts working on the Street are pretty bright -- but that doesn't necessarily work to your advantage.

You see, just because a sell-side analyst believes a stock is a dud, that doesn't necessarily mean he's going to clue you in to this fact. Think back to that 2002 TV ad where the pinstriped broker tells his analyst: "Let's put some lipstick on this pig!" That's how the game was played pre-millennium. Analysts might have had private reservations -- heck, they might have had a private case of the giggles -- about the prospects for a stock. But that certainly didn't mean they were going to rate it a sell.

Remember, these people have commissions to earn. And they don't make commissions by telling people who don't own a stock that they shouldn't own it. They make commissions by telling people who don't own a stock that they need to buy it right now.

And of course, if their private belief that the company is doomed turns out to be right, there's plenty of time down the road to make a second commission by opining that the circumstances have now changed and it's time to sell that stock they told you to buy three months ago.

Gurus gone mildBut the desire to make sales and earn commissions is only half the story. The other reason that Wall Street analysts tend to make bad calls in public -- even when they're right in private -- is the fact that they are (not to put too fine a point on it) a bunch of desk-bound, paycheck-driven bureaucrats.

Try to look at life from the other side of the analyst's desk for a moment and you'll see what I'm getting at. Let's say that in 2000, an analyst had to make a decision between recommending Internet giant (at the time) Time Warner(NYSE:TWX) or boring conglomerate Loews(NYSE:LTR) -- a supposedly stable stock that had been falling since 1998.

At the time, few people suspected that in the next seven years, Time Warner's stock would lose 70% while Loews' would gain 370%. And of those analysts who did see the potential in Loews, few were willing to bet their jobs on it.

Herd mentalityTo see why that's so, let's turn for a moment to legendary investor and former head of the Fidelity Magellan fund, Peter Lynch. He summed up Wall Street analysts' thinking on questions such as the Time Warner-Loews dilemma thusly: "Success is one thing, but it's more important not to look bad if you fail."

Sure, an analyst could have made his clients a lot of money by seeing the value inside Loews, the potential for outsized returns just waiting to be unlocked. But what if the analyst was wrong? When all of your colleagues are pointing out a company's problems, do you go out on a limb and say: "I beg to differ"? Probably not. Because if you're wrong, you'll be begging -- begging for your job.

Now contrast that with what happens when an analyst puts a "buy" recommendation on a stock such as XM Satellite Radio, which recently proposed a merger with Sirius Satellite Radio to cap what has otherwise been a downright awful 16 months for the stock. And yet even after such a terrible performance, analysts still have 15 "buy" ratings on the stock, 14 "holds," and not a single "sell." Now, if everyone is sure that a stock will go up, and it does, it's all good. On the other hand, if the merger fails and the stock tanks, everyone will gasp in mock amazement: "Wow. XM really made a mess of things."

Thus, analysts have learned that there's safety in numbers. The cow that wanders from the herd gets eaten by wolves (or thrown to them by an irate mutual fund manager). But as long as the analyst sticks with the rest of the cattle, it doesn't much matter whether the herd's moving in the right direction or the wrong -- the analyst's job is safe.

Be the cowboy, not the cowAs an individual investor, however, you don't have to be part of the herd. Like a cowboy circling on the outside, you can watch as the cows shamble to and fro, yet move independently yourself. When the analysts are all chanting "buy, buy" and charging toward a cliff, you can just step out of the way. And when they're bellowing "sell, sell" and rushing off to greener pastures on the other side of some fence, you can wait until they're gone and examine what they're leaving behind. Could be that you'll find it right tasty.

Now, mind you, any pasture that the analyst herd is so eager to leave is probably laden with certain, er, land mines. So you do want to watch your step as you go a-grazing. That's where our researchers at the Motley Fool Inside Value newsletter service can help. They're adept at picking their way through well-used fields of abandoned stocks, locating and avoiding the land mines, and finding tasty treats such as Inside Value pick Wal-Mart(NYSE:WMT). The company has a number of solid competitive advantages, plans for further growth, and an improving public image -- and it currently sells at a discount to its intrinsic value. In fact, since the newsletter first began publishing in 2004, it has already found more than 40 such stocks for subscribers. If you'd like to take a look at our research, click here to join the service free for 30 days. There is no obligation to subscribe.

This article was originally published on April 28, 2005. It has been updated.

Fool contributor Rich Smith does not own shares of any company mentioned in this article. Yahoo!, Priceline, and Time Warner are Stock Advisor recommendations. Wal-Mart is an Inside Value choice. The value of The Motley Fool's disclosure policy is a definite "buy."

Author

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.
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